Chapter 18
Externalities and
Public Goods
Topics to be Discussed

Externalities

Ways of Correcting Market Failure

Externalities and Property Rights

Common Property Resources
Chapter 18
Slide 2
Topics to be Discussed

Public Goods

Private Preferences for Public Goods
Chapter 18
Slide 3
Externalities

Negative


Action by one party imposes a cost on
another party
Positive

Chapter 18
Action by one party benefits another
party
Slide 4
External Cost

Scenario

Steel plant dumping waste in a river

The entire steel market effluent can be
reduced by lowering output (fixed
proportions production function)
Chapter 18
Slide 5
External Cost

Scenario

Marginal External Cost (MEC) is the cost
imposed on others for each level of
production.

Marginal Social Cost (MSC) is MC plus
MEC.
Chapter 18
Slide 6
External Costs
Price
When there are negative
externalities, the marginal
social cost MSC is higher
than the marginal cost.
The differences is
the marginal external
cost MEC.
MSC
The profit maximizing firm
produces at q1 while the
efficient output level is q*.
Price
MSCI
MC
S = MCI
The industry competitive
output is Q1 while the efficient
level is Q*.
Aggregate
social cost of
negative
externality
P*
P1
P1
MECI
MEC
D
q* q1
Firm output
Q* Q1
Industry output
External Cost

Negative Externalities encourage
inefficient firms to remain in the
industry and create excessive
production in the long run.
Chapter 18
Slide 8
Externalities

Positive Externalities and Inefficiency

Chapter 18
Externalities can also result in too little
production, as can be shown in an
example of home repair and
landscaping.
Slide 9
External Benefits
Value
When there are positive
externalities (the benefits
of repairs to neighbors),
marginal social benefits
MSB are higher than
marginal benefits D.
MSB
D
P1
A self-interested home owner
invests q1 in repairs. The
efficient level of repairs
q* is higher. The higher price
P1 discourages repair.
MC
P*
Is research and development
discouraged by positive
externalities?
MEB
q1
Chapter 18
q*
Repair Level
Slide 10
Ways of Correcting Market Failure

Assumption: The market failure is
pollution


Chapter 18
Fixed-proportion production technology

Must reduce output to reduce
emissions

Use an output tax to reduce output
Input substitution possible by altering
technology
Slide 11
The Efficient Level of Emissions
Dollars
per unit
of Emissions
Assume:
1) Competitive market
2) Output and emissions decisions are independent
3) Profit maximizing output chosen
MSC
6
At Eo the marginal
cost of abating emissions
is greater than the
marginal social cost.
Why is this more efficient
than zero emissions?
4
At E1 the marginal
social cost is greater
than the marginal benefit.
The efficient level of
emissions is 12 (E*) where
MCA = MSC.
2
MCA
E0
0 2 4 6 8 10
Chapter 18
E*
12 14
16
E1
18 20
22
24
Level of Emissions
26
Slide 12
Ways of Correcting Market Failure

Options for Reducing Emissions to E*

Chapter 18
Emission Standard

Set a legal limit on emissions at E*
(12)

Enforced by monetary and criminal
penalties

Increases the cost of production and
the threshold price to enter the
industry
Slide 13
Standards and Fees
Dollars
per unit
of Emissions
MSC
Standard
Fee
3
MCA
E*
12
Chapter 18
Level of Emissions
Slide 14
Ways of Correcting Market Failure

Options for Reducing Emissions to E*

Emissions Fee

Chapter 18
Charge levied on each unit of
emission
Slide 15
Standards and Fees
Dollars
per unit
of Emissions
MSC
Cost is less than the
fee if emissions were
not reduced.
Fee
3
Total Fee
of Abatement E*
Total
Abatement Cost
MCA
12
Chapter 18
Level of Emissions
Slide 16
Ways of Correcting Market Failure

Standards Versus Fees

Chapter 18
Assumptions

Policymakers have asymmetric
information

Administrative costs require the same
fee or standard for all firms
Slide 17
The Case for Fees
Fee per
Unit of
Emissions
The impact of a standard of
abatement of 7 for both firms
is illustrated.
Not efficient because
MCA2 < MCA1.
MCA1
MCA2
If a fee of $3 was imposed
Firm 1 emissions would fall
by 6 to 8. Firm 2 emissions
would fall by 8 to 6.
MCA1 = MCA2: efficient solution.
6
The cost minimizing solution
would be an abatement of 6
5
for firm 1 and 8 for firm 2 and
MCA1= MCA2 = $3.
4
3.75
3
Firm 1’s Increased
Abatement Costs
2.50
2
Firm 2’s Reduced
Abatement
Costs
1
0
Chapter 18
1
2
3
4
5
6
7
8
9
10
11
12
13
Level of
14 Emissions
Slide 18
Ways of Correcting Market Failure

Advantages of Fees

When equal standards must be used,
fees achieve the same emission
abatement at lower cost.

Fees create an incentive to install
equipment that would reduce emissions
further.
Chapter 18
Slide 19
The Case for Standards
C
Fee per
Unit of 16
Emissions
Marginal
Social
Cost
14
12
Based on incomplete
information fee is $7
(12.5% reduction).
Emission increases to 11.
ABC is the increase
in social cost less the
decrease in abatement
cost.
E
10
A
D
8
Based on incomplete
information standard is 9
(12.5% decrease).
ADE < ABC
B
6
Marginal Cost
of Abatement
4
2
0
Chapter 18
2
4
6
8
10
12
14
16
Level of Emissions
Slide 20
Ways of Correcting Market Failure

Summary: Fees vs. Standards

Standards are preferred when MSC is
steep and MCA is flat.

Standards (incomplete information) yield
more certainty on emission levels and
less certainty on the cost of abatement.
Chapter 18
Slide 21
Ways of Correcting Market Failure

Summary: Fees vs. Standards

Fees have certainty on cost and
uncertainty on emissions.

Preferred policy depends on the nature
of uncertainty and the slopes of the cost
curves.
Chapter 18
Slide 22
Ways of Correcting Market Failure

Transferable Emissions Permits

Chapter 18
Permits help develop a competitive
market for externalities.

Agency determines the level of
emissions and number of permits

Permits are marketable

High cost firm will purchase permits
from low cost firms
Slide 23
Externalities and Property Rights

Property Rights

Legal rules describing what people or
firms may do with their property

For example

Chapter 18
If residents downstream owned the
river (clean water) they control
upstream emissions.
Slide 24
Externalities and Property Rights

Bargaining and Economic Efficiency

Chapter 18
Economic efficiency can be achieved
without government intervention when
the externality affects relatively few
parties and when property rights are well
specified.
Slide 25
Profits Under Alternative
Emissions Choices (Daily)
Factory’s
Profit
Fishermen’s
Profit
Total
Profit
No filter, not treatment plant
500
100
600
Filter, no treatment plant
300
500
800
No filter, treatment plant
500
200
700
Filter, treatment plant
300
300
600
Chapter 18
Slide 26
Externalities and Property Rights


Assumptions

Factory pays for the filter

Fishermen pay for the treatment plant
Efficient Solution

Chapter 18
Buy the filter and do not build the plant
Slide 27
Bargaining with
Alternative Property Rights
Right to Dump Right to Clean Water
No Cooperation
Profit of factory
Profit of fishermen
$500
$200
$300
$500
$550
$250
$300
$500
Cooperation
Profit of factory
Profit of fishermen
Chapter 18
Slide 28
Externalities and Property Rights

Conclusion: Coase Theorem

Chapter 18
When parties can bargain without cost
and to their mutual advantage, the
resulting outcome will be efficient,
regardless of how the property rights are
specified.
Slide 29
Externalities and Property Rights

Costly Bargaining --- The Role of
Strategic Behavior

Chapter 18
Bargaining requires clearly defined rules
and property rights.
Slide 30
Externalities and Property Rights

A Legal Solution --- Suing for
Damages

Fishermen have the right to clean water

Factory has two options

No filter, pay damages


Profit = $100 ($500 - $400)
Filter, no damages
 Profit
Chapter 18
= $300 ($500 - $200)
Slide 31
Externalities and Property Rights

A Legal Solution --- Suing for Damages

Factory has the right to emit effluent

Fishermen have three options
Put

in treatment plant
Profit = $200
Filter

No

Chapter 18
and pay damages
Profit = $300 ($500 - $200)
plant, no filter
Profit = $100
Slide 32
Externalities and Property Rights

Conclusion


A suit for damages results in an efficient
outcome.
Question

Chapter 18
How would imperfect information impact
the outcome?
Slide 33
The Coase Theorem at Work

Negotiating an Efficient Solution

1987 --- New York garbage spill (200
tons) littered the New Jersey beaches
The
potential cost of litigation resulted
in a solution that was mutually
beneficial to both parties.
Chapter 18
Slide 34
Common Property Resources

Common Property Resource

Everyone has free access.

Likely to be overutilized

Examples
Chapter 18

Air and water

Fish and animal populations

Minerals
Slide 35
Common Property Resources
Without control the number
of fish/month is FC where
PC = MB.
Benefits,
Costs
($ per
fish)
Marginal Social Cost
However, private costs
underestimate true cost.
The efficient level of
fish/month is F* where
MSC = MB (D)
Private Cost
Demand
F*
Chapter 18
FC
Fish per Month
Slide 36
Common Property Resources

Solution


Private ownership
Question

Chapter 18
When would private ownership be
impractical?
Slide 37
Crawfish Fishing in Lousiana

Finding the Efficient Crawfish Catch
F
= crawfish catch in millions of
pounds/yr
C
Chapter 18
= cost in dollars/pound
Slide 38
Crawfish Fishing in Lousiana

Demand
C

MSC
C

= 0.401 = 0.0064F
= -5.645 + 0.6509F
PC
C
Chapter 18
= -0.357 + 0.0573F
Slide 39
Crawfish Fishing in Lousiana

Efficient Catch
 9.2
D
Chapter 18
million pounds
= MSC
Slide 40
Crawfish as a Common
Property Resource
C
Cost
(dollars/pound)
Marginal Social Cost
2.10
Private Cost
0.325
Demand
9.2
Chapter 18
11.9
Crawfish Catch
(millions of pounds)
Slide 41
Public Goods

Question

Chapter 18
When should government replace firms
as the producer of goods and services?
Slide 42
Public Goods

Public Good Characteristics

Nonrival


Nonexclusive

Chapter 18
For any given level of production the
marginal cost of providing it to an
additional consumer is zero.
People cannot be excluded from
consuming the good.
Slide 43
Public Goods

Not all government produced goods
are public goods

Chapter 18
Some are rival and nonexclusive

Education

Parks
Slide 44
Efficient Public Good Provision
Benefits
(dollars)
When a good is nonrival, the social marginal
benefit of consumption (D) , is determined by
vertically summing the individual demand
curves for the good.
$7.00
Marginal Cost
$5.50
D2
$4.00
Efficient output occurs
where MC = MB at 2
units of output. MB is
$1.50 + $4.00 or $5.50.
D
$1.50
D1
0
Chapter 18
1
2
3
4
5
6
7
8
9
10
Output
Slide 45
Public Goods

Public Goods and Market Failure

Chapter 18
How much national defense did you
consume last week?
Slide 46
Public Goods

Free Riders

There is no way to provide some goods
and services without benefiting
everyone.

Households do not have the incentive to
pay what the item is worth to them.

Free riders understate the value of a
good or service so that they can enjoy its
benefit without paying for it.
Chapter 18
Slide 47
Public Goods

Establishing a mosquito abatement
company

How do you measure output?

Who do you charge?

A mosquito meter?
Chapter 18
Slide 48
The Demand for Clean Air

Clean Air is a public good


Nonexclusive and nonrival
What is the price of clean air?
Chapter 18
Slide 49
The Demand for Clean Air

Choosing where to live

Chapter 18
Study in Boston correlates housing
prices with the quality of air and other
characteristics of the houses and their
neighborhoods.
Slide 50
The Demand for Clean Air
Dollars
High Income
3000
2500
Middle Income
2000
Low Income
1500
1000
500
0
Chapter 18
1
2
3
4
5
6
7
8
9
10
Nitrogen Oxides
(pphm)
Slide 51
The Demand for Clean Air

Findings

Amount people are willing to pay for clean air
increases substantially as pollution increases.

Higher income earners are willing to pay more
(the gap between the demand curves widen)

National Academy of Sciences found that a
10% reduction in auto emissions yielded a
benefit of $2 billion---somewhat greater than
the cost.
Chapter 18
Slide 52
Private Preferences for Public Goods

Government production of a public
good is advantageous because the
government can assess taxes or fees
to pay for it.

Determining how much of a public
good to provide when free riders exist
is difficult.
Chapter 18
Slide 53
Determining the Level
of Educational Spending
Willingness
to pay
$
The efficient level of educational
spending is determined by summing the
willingness to pay for education for each
of three citizens.
AW
W1
$0
Chapter 18
$600
W2
$1200
W3
$1800
$2400
Educational spending
per pupil
Slide 54
Determining the Level
of Educational Spending
Willingness
to pay
$
Will majority rule yield an efficient outcome?
•W1 will vote for $600
•W2 and W3 will vote for $1200
The median vote will always win in a majority
rule election.
AW
W1
$0
Chapter 18
$600
W2
$1200
W3
$1800
$2400
Educational spending
per pupil
Slide 55
Private Preferences for Public Goods

Question


Will the median voter selection always
be efficient?
Answer

If two of the three preferred $1200 there
would be overinvestment.

If two of the three preferred $600 there
would be underinvestment.
Chapter 18
Slide 56
Private Preferences for Public Goods

Majority rule is inefficient because it
weighs each citizen’s preference
equally---the efficient outcome weighs
each citizen’s vote by his or her
strength of preference.
Chapter 18
Slide 57
Summary

There is an externality when a producer or
a consumer affects the production or
consumption activities of others in a
manner that is not directly reflected in the
market.

Pollution can be corrected by emission
standards, emissions fees, marketable
emissions permits, or by encouraging
recycling.
Chapter 18
Slide 58
Summary

Inefficiencies due to market failure
may be eliminated through private
bargaining among the affected
parties.

Common property resources are not
controlled by a single person and can
be used without a price being paid.
Chapter 18
Slide 59
Summary

Goods that private markets are not
likely to produce efficiently are either
nonrival or nonexclusive. Public
goods are both.

A public good is provided efficiently
when the vertical sum of the individual
demands for the public good is equal
to the marginal cost of producing it.
Chapter 18
Slide 60
Summary

Under majority rule voting, the level of
spending provided will be that
preferred by the median voter---this
need not be the efficient outcome.
Chapter 18
Slide 61
End of Chapter 18
Externalities and
Public Goods